Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Sunday, December 22, 2013

E.U. Parliament and Member States Reach Deal on Legislation to Reform Audit Reports and Mandate Audit Firm Rotation

In a major
step, the European Parliament and the E.U. Member States have reached agreement
on legislation to reform the audit report on company financial statements and
require the mandatory rotation of audit firms. In order to promote competition, the legislation also would
prohibit restrictive Big Four only third party clauses imposed on companies. A
lack of choice for audit clients resulting from high concentration levels, in
essence an oligopoly, is what the legislation aims to correct. Audit quality
derives from independence, professional skepticism and technical competence. The
European Commission believes that all of these elements will be enhanced by the
proposed reforms and consequently, audit quality as a whole will be improved.

Although less ambitious than initially
proposed by the Commission, stated
Commissioner for the Internal Market Michel Barnier, landmark measures to
strengthen the independence of auditors have been endorsed in the legislative
agreement, particularly in the auditing of financial institutions and listed
companies. This will ensure that auditors will be key contributors to economic
and financial stability.

Mandatory
rotation. Audit firms
would be required to rotate after an engagement period of 10 years. The ten
year period could be extended by up to 10 additional years if tenders are
carried out, and by up to 14 additional years in case of joint audit under
which the company being audited appoints more than one audit firm to carry out
its audit. A calibrated transitional period taking into account the duration of
the audit engagement is foreseen to avoid a cliff effect following the entry
into force of the new rules.

Mandatory auditor rotation is based on the
rationale that a long professional relationship undermines auditor independence
and negatively impacts on auditor professional skepticism. The Commission
rejected the idea of simply rotating the key audit partner as insufficient
because the main focus would still be client retention. A new partner would be
under pressure to retain a long standing client of the firm, reasoned the
Commission, and it would be unlikely that he or she would criticize the work of
the previous audit partner. During the comment period, the Big Four audit firms
opposed mandatory audit firm rotation and endorsed the current market-driven
selection of outside auditors.

Audit
report. In order to
reduce the expectation gap between what is expected from auditors and what they
are bound to deliver, the legislation would require auditors to produce more
detailed and informative audit reports, with a required focus on relevant
information to investors. Closer cooperation between the auditor, the audit
committee and supervisors will also help to clarify and meet the expectations of
stakeholders.

Non-audit
services. Audit firms
will be strictly prohibited from providing non-audit services to their audit
clients, including stringent limits on tax advice and services linked to the
financial and investment strategy of the audit client. This aims to limit risk
of conflicts of interest, when auditors are involved in decisions impacting the
management of a company. This is designed to substantially limit the
self-review risks for auditors. To reduce the risks of conflicts of interest,
the new rules would introduce a cap of 70 percent on the fees generated for
non-audit services others than those prohibited based on a three-year average
at the group level.

Oversight.
Strict transparency
requirements would be introduced for auditors with stronger reporting
obligations vis-à-vis supervisors. The work of auditors would be closely
supervised by audit committees, whose competences are strengthened by the
legislation. In addition, in a very novel and innovative change, the legislative
package introduces the possibility for 5 percent of the shareholders of the
company to initiate actions to dismiss the auditors. A set of administrative
sanctions that can be applied by the competent authorities is also foreseen for
breaches of the new rules.

Cross-border.
The legislation would
also provide a level playing field for auditors at the E.U. level through
enhanced cross-border mobility and the harmonization of International Standards
on Auditing (ISAs). Cooperation between national supervisors will be enhanced
at the E.U. level, with a specific role devoted to the European Markets and
Securities Authority (ESMA) with regard to international cooperation on audit
oversight.